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The Ugly Truth About Stop Loss Orders

Since you have landed here I can say with high confidence that you have heard the following term before…

Stop loss.

The old stop loss order…an order typically used as a closing order to limit your losses on a trade or investment.

And fortunately for those fans of stop loss orders, they come in many different shapes and sizes:

Stop Loss: an order that triggers a market order when the marked price hits the stop price

Stop Loss Limit: an order that triggers a limit order when the market price hits the stop price

Trailing Stop: an order that triggers a market order when the market price goes against the position by the stop amount

Training Stop Limit: an order that triggers a limit order when the market price goes against the position by the stop amount

Here is a video on how to set stop loss orders:

Can We Move on Now?

I hope the above is that last time you will ever consider anything about stop losses EVER again.

I will explain exactly how throughout the rest of this article but rest assure, after reading this you will NEVER use a stop loss ever again…

Before we can jump in, we must have a little chit chat.

How Much Can a Stock Move?

Believe it or not, a stocks expected move in any given time frame is 100% quantifiable.

So what does this mean?

It means: how much a stock can move in any given time frame can be found in less than 30 seconds.

And I will show you how just in one minute but first…

Delta, Delta, Delta

Every stock (minus a very small number) has derivatives known as options.

Most people know of options as a way to get leverage on your side, and POTENTIALLY get a high return for a small investment…

But while this may be true, we are going to use options to tell us the likelihood of a stock getting to a certain price in a certain time frame.

So what’s this delta thing?

A Deeper Dive

Now that you have a high level understanding of delta…

We can dig in a little further.

Watch the video below and I will walk through the example in the infographic above…

What Does This Have to Do With Stop Losses?

Actually, it have everything to do with it…

I want you to commit the following to memory…

Write it down…

Repeat it 100 times…

Do whatever you can to remember the following…

Because I PROMISE you, you will never ever ever in a million years hear this anywhere else…

THE DELTA OF A STOCK OPTION IS EQUIVALENT TO THE CHANCES OF THE STOCK FINISHING IN THE MONEY AT THE TIME OF EXPIRATION

Here is the example from the above video:

But Isn’t a Stop Triggered When it ‘Touches’ the Stop Price?

Yup.

Then let’s circle around and talk to our friend Mr. Delta again.

If $AAPL has an 11% chance of finishing above $120 based off an 11 delta, what are the chances we TOUCH $120?

Drum roll please…

DOUBLING THE DELTA OF A STOCK OPTION IS EQUIVALENT TO THE CHANCES OF THE STOCK TOUCHING THE STRIKE PRICE AT ANY TIME BEFORE EXPIRATION

Starting to make sense right?

Wait?

Are you saying…

That if I double the delta of a stock option that tells me the chances the stock touches the strike price during the life span of the option?

Yes 🙂

So then if that must be true…

Then we can tell the chances of the stock touching any price in any time frame?

You got it!

Back to Our Old Friend Mr. Stop Loss

Now that you are officially light years ahead of 99.9% of investors out there, we are still not done.

We have to tie this back to stop losses.

But wait…

Are you telling me we now have the knowledge to know the chances that we will be stopped out?

YES!

Back to Apple

By now you know I never use stop losses.

And the good news is.

I know you feel the same way.

Especially after this last section.

But just to put some context around stop losses, let’s assume when we make a trade, we put a stop loss limit order in 2% below the current price of the stock. We don’t want to lose more than 2% of anything do we?

Watch the video below to find out:

Man!

80% chance of being stopped out!

Who would sign up for that?

Nobody! Especially not you since you now have the ability to have reasonable expectations around price movement.